Robeco Outlook 2014 - Backing the right horse

Backing the right horse Robeco Outlook 2014 For professional investors only

look back

What directed investors in 2013?

> click here to see the full infographic

Ben Bernanke was the No 1 conductor of the financial market movements in 2013.

What were the major headlines?

contents

introduction

4 Investors will use their capital more actively Interview 7 J apanese regain confidence in their country’s strength Asia-Pacific

8 Backing the right horse: Equities set to rise further in 2014 Asset allocation 0 Don’t expect a great rotation in 2014 1 Fixed income 11 Earnings bode well for equities US markets

Return to growth The past five years have witnessed the worst financial conditions since the thirties: banking collapses were followed by debt defaults, bailouts, recession and austerity. The past two years have seen partial recovery, as the Eurozone stabilized and economies pulled out of trouble. The recovery was aided by unprecedented monetary stimulus – and now, at last, we seem to have returned to growth.

In our outlook for 2014 we see increased growth in all the major global economies, and as a result, the end of trillion-dollar quantitative easing programs. This will usher in the end of easy money through historically low interest rates and a return to ’business as usual’. Company earnings should drive equity markets instead of artificial stimulus, and rising interest rates should dictate bond values rather than QE. So what does this mean for investors? Of course, every investor wants to back the right horse – but which assets to choose? Our chief economist believes that equities are the preferred asset class in 2014. He discusses how an improving global economy, led by the US, and the expected introduction of tapering by the US Federal Reserve bodes well for stocks. Within fixed income, we detail how we prefer high-yield bonds to sovereign debt as rising interest rates mean government bond values will fall.

In the US, the very positive outlook for equities is highlighted by Jay Feeney, Chief Investment Officer of Boston-based Robeco Investment Management.

He outlines how ultimately it is company earnings that drive markets, and he forecasts share price growth of 7-9% next year, thanks to the strong financial health of US corporates.

For Asia, Arnout van Rijn, Chief Investment Officer for the Asia Pacific region, discusses how the Far East continues to offer opportunities to investors into 2014. Japan and South Korea are his favorites, and China is particularly attractive to stock pickers. But bond investors should beware, as loans in this region are sensitive to the Fed’s tapering policy.

2014 – Year of the Horse 2014 is the Chinese year of the horse, and the use of this animal that is revered in many cultures would seem appropriate to describe the prospects for next year.

Finally, Kommer van Trigt, head of the Robeco Rates team, argues that there still is healthy demand for bonds. According to him there won´t be a ‘great rotation’ from fixed income into stocks in 2014. His comments are based on a video interview which can be viewed at our website: www.robeco.com.

2014 should be an interesting, and financially rewarding, year – and we hope that you find our outlook for it useful.

For the global economy, it is a case of ‘getting back on the horse’, after 2013 and 2012 were both years of muddling through after the debt crisis of 2011.

For investors, ‘backing the right horse’ is always the priority – we recommend equities and high-yield bonds.

Hans Rademaker Chief investment officer

robeco outlook 2014

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INTERVIEW

“ Investors will use their capital more actively�

Hans Rademaker, Chief Investment Officer at Robeco and member of the management board

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Clearly, investors want returns. But they will increasingly make new demands too, predicts Hans Rademaker, Chief Investment Officer at Robeco.

As 2013, a good year for investments, nears its close, we speak to Hans Rademaker about the outlook for the new year. Rademaker, who has been on Robeco’s Management Board since 2010, prefers to look beyond the 12 months of 2014 that lie ahead. The bigger issue of constantly changing cultural, socioeconomic and social trends fascinates the 51-year old executive. Rademaker also considers demographic shifts when formulating his outlook on the investment industry, his view on future capital flows, and on investment risks and opportunities.

Which trend do you find particularly significant?

“The population growth is high; possibly even irresponsibly high. Keep in mind that 200 years ago, in the 1800s, the world’s population amounted to no more than one billion people.

Today, this number is expected to increase to the nine-billion level by 2015. That is a massive growth rate. This prognosis is much higher than the United Nations initially thought, and it raises fundamental questions about how we live.”

What is the greatest strain caused by population growth?

“Demographic changes are a fact. They cannot be substantially speeded up or slowed down.

And the question that explosive growth of this nature raises is: what to do with the world’s already scarce resources? If population growth continues at this rate, we will find ourselves faced with numbers that we can no longer sustain in the very long term.

How does this trend affect investors?

“The inevitable trend is towards increasingly applying the principles of sustainability to our planet, and in fact our entire eco-system. It makes no difference whether we are dealing with conservation of resources such as iron ore, grain or water, or with the supply of food and

robeco outlook 2014

environmental preservation in a broader sense.

Here I see a clear change taking place in the investment industry.

The shift is from passive to active participation.

Currently, institutional investors still mainly monitor their investments passively. But I believe this will change and we will move from passive to active investing. In the so-called ‘voting and engagement’ approach, investments will firstly be assessed for their score on environmental, social and governance (ESG) factors. This will be followed by voting at shareholder meetings and dialogues initiated with companies. People will increasingly wish to use their assets to attain a particular goal that benefits society in their eyes, without losing out in terms of returns.”

goals. Their investments must clearly generate returns. And these requirements dictate that we provide a dual service: on the one hand, striving to achieve a good risk-return profile, and on the other, attaining the results that providers of capital consider important.”

What is the driving force behind this active use of capital?

“An active approach of this kind is not - or hardly ever - used today. It is still in its infancy.

But I see this as a growth area. People want to know what is being done with their money; they want to have more control themselves and have an impact, provided that in the end they optimize their financial returns. Pension funds and other institutional investors must meet these requirements.”

‘Longevity is increasing, and the need for capital protection is becoming greater than ever as a result’ Isn’t that too good to be true? Returns plus actively pursuing goals?

“I think these can go together. Many people are still pre-conditioned to believe that this concept of investing will cost them returns.

But it is possible to create an optimal risk/ return ratio and at the same time to use your capital more actively to achieve a specific goal.

Take a pension fund in the healthcare sector, for example, that wishes to use its capital to contribute towards creating a healthier society. Such a fund can invest extra assets in companies that make fitness machines or in firms that work towards combating obesity, as this is related to the sector in which they operate.

Society wishes to use its capital actively.

Providers of capital do not wish to simply subsidize, or to strive for purely idealistic

While in parts of Asia there is a young population, the opposite is true in the aging Western societies.

What are the consequences?

“In Western countries, a reversal is taking place, where pension funds are switching from collecting money to paying out money on a net basis. This results in demand for different kinds of investment. Longevity is increasing, and the need for capital protection is becoming greater than ever as a result. The traditional insurance policies used to maintain the value of accrued assets do not provide this protection as they have become prohibitively expensive at the current low rates of interest.

Western society will not put up with major capital losses because there is no longer any way of recovering them. A situation in which savings of EUR 100,000 halve in value by next year is not acceptable. People may be prepared

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INTERVIEW

to accept stock prices that fall for a while, but they will no longer be able to absorb shocks like those suffered during the tech bubble and the credit crisis, with losses of as much as 50%. In addition, retirees wish to draw a regular income from their accrued assets. So this money must be easily accessible.

Demographic change has been a fact for years, yet product development to meet its needs is still lagging behind. But we are now rapidly approaching the turning point, and appropriate financial products are being developed.”

Sounds like a good time for bonds?

“Yes it sounds like it, except for the fact that high-quality bonds yield little at the moment.

This adds further complexity. The attractive premiums available on corporate bonds are also diminishing. However, bond products will always remain necessary anchors in a portfolio, even with such minimal yields. As a pension fund or large institutional investor you want to avoid too much volatility and loss of capital, particularly with an aging target group. Bonds provide a buffer against volatility, but returns were higher a few years ago than they are today.”

Are we living in an asset bubble?

“I would not go as far as calling this a bubble.

But tapering – reducing the Fed’s bond-buying program – must take place sooner or later.

The monetary experiment will cease. No, you can’t go on trying gimmicks and shifting things around to resolve our global economic problems. You can’t just go on endlessly buying to support the markets, as the pressure in the keg will keep rising, and the underlying issues that actually have to be resolved will steadily increase in magnitude. Ultimately, only real economic growth will provide a solution to these problems. “

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Can the Fed reduce these stimulus measures without causing problems, or are we too addicted to its support?

“No-one has experienced this 25 times before.

I believe reducing cheap money can be done in a controlled way, but not all market parties are convinced of this, or can cope with it. For this reason it would not surprise me if we have two or three periods with very strong interest-rate fluctuations before everything settles down.

The flight out of emerging markets this year was a warning signal. It showed that the mere announcement of tapering was enough to move things onto a completely different track.

But the central banks will be focused on making the adjustment process as manageable as possible. “

What is your advice to investors?

“My philosophy is that there are always opportunities in every situation. That is true whether you find yourself in a bubble, or in a bear market, or somewhere in between. There are always chances and opportunities. But we must be ready to adapt. We shouldn’t have any illusions that a single approach will always work.

My investor’s heart says that you shouldn’t avoid risk. Quite the opposite: seek out risk, but make sure that you are rewarded accordingly.

Don’t make this a goal in itself – but if it is generally possible to be sufficiently rewarded, then you should be happy to be able to take on a little more risk instead of constantly evading or hedging it. Incidentally, it is interesting to note that equities currently have an historically high risk premium.”

‘Massive population growth is raising questions about how we live’

9 bn World population in 2050

>60 years Half of the population

143% Population growth between 1950 - 2000 Source: United Nations

‘My investor’s heart says that you shouldn’t avoid risk’

asia-pacific

Japanese regain confidence in their country’s strength Arnout van Rijn, CIO Asia-Pacific The Far East continues to offer opportunities to investors into 2014. Japan and South Korea are favorites, and China is particularly attractive to stock pickers. But bond investors beware! Loans in this region are sensitive to the Fed’s ‘tapering’ policy.

Over the coming year, the monetary policy of central banks in both East and West will once again play an important role in equity markets in the Asia-Pacific region. However, though monetary policy worked out positively last year, thanks to a large injection of liquidity from the rest of the world, the picture is now more nuanced. ‘Tapering’ in the US is likely to have a negative effect. Counteracting this is the Japanese central bank’s fanatical persistent money printing.

sentiment. The Japanese have lived for donkeys’ years with a tight hand on the purse strings, but are now starting once again to believe in their country’s strength. And that is leading to higher consumption and investments. I am also positive about corporate earnings development. Further, the valuation of the stock market provides scope for further price gains.

China offers opportunities for stock pickers in particular. Economic growth will weaken

‘Japanese stimulus policies appear to be reversing market sentiment’ The Japanese economy and equity market will benefit from this. A weak yen and relaxed budget policies will generate a similar positive impact. And though the increase in sales tax in April will create uncertainty and could result in lower growth in the second half of the year, I think this shows the government aims to keep its finances under control.

But do not expect too much from the third pillar supporting the government’s policies – structural reform. And that is a shame, as changes to the labor market and the tax system are necessary to drive economic growth to a higher level for the longer term. However, over the short term, the key factor is that the stimulus policies appear to be reversing

robeco outlook 2014

somewhat, mainly because the ‘boom’ in corporate investment is unsustainable. But one positive factor is that the new leaders are implementing market-oriented reforms. Private initiative is being encouraged, and that is a good thing. Most listed companies are public concerns that struggle with fiercer competition, and therefore face lower margins. The most attractive stocks are not going to be found over the coming year in the financials sector or the steel and cement industries. Dynamic companies in private hands are mainly active in the alternative energy, internet, environmental technology, health care and consumer sectors.

Other Asian markets have I think been trending for some time in a ‘range’ that they are unlikely to break out of in the coming year. Many

companies have benefited from low rates driven by the broad-based interest in the region’s bonds. An increase in interest rates worldwide, which we expect in 2014, is unfavorable for highly leveraged businesses, with India and Southeast Asian countries most vulnerable in this regard.

South Korea has not seen such inflows into the bond market and will not be affected by higher interest rates. Further, I expect growth there to recover after a period of weakness. The Korean market features many interesting companies with low valuations.

Increases in long-term interest rates in the West owing to the tapering of money printing in the US will weaken demand for emerging debt. I do not expect this investment category – so popular in recent years – to fall out of grace entirely, but caution is called for.

All things considered, the challenge is to make the right investment choices in the Chinese year of the horse. The Japanese equity market – driven as it is by money printing – will in my opinion continue to gallop swiftly like last year. In the rest of the region, I see equity prices going ‘sideways’ under pressure from higher interest rates. So at the very least avoid investing in index funds in these markets.

Bottom-up stock selection is where the party is over the coming year. So make sure you back the winning horses.

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asset allocation

Backing the right horse:

Equities set to rise further in 2014 Equities are set to rise further in 2014 after the world returns to normality, with higher global growth and the end of easy money in the US. These are the key predictions of Robeco’s Chief Economist Léon Cornelissen in his outlook for markets next year.

Stocks are Robeco’s preferred asset class for 2014, although returns may not be as strong as in 2013, when the MSCI World Index rose almost 16% in the first 10 months of the year in euros on the back of stimulus from quantitative easing (QE) programs.

“2014 will be a year in which higher-risk investment categories will provide satisfactory returns,” says Cornelissen. “Expanding global growth combined with continuing loose monetary policy favors higher-risk asset classes.”

High-yield bonds are favored in the fixed income sphere, as the end of QE – beginning with tapering by the US Federal Reserve (Fed) expected from the Spring – signals a new era of rising interest rates. This makes the returns on high-yield debt relatively more attractive than those available on sovereign bonds.

Politics will be the unpredictable part However some political risk remains. The Eurozone has come a long way since the height of the euro crisis in 2011, with growth expected to rise towards 1% in 2014. “Less emphasis on austerity will support recovery in the Eurozone”, says Cornelissen. “This will mean that earlier deficit targets will again not be achieved.”

“It is very unlikely that the European Commission will impose fines on miscreant

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nations; just as unlikely is a fine for Germany because of its continuing excessive current account surplus. Although in theory the Commission’s powers for achieving a more

Europe, and will be expanded in Japan,” says Cornelissen. He predicts that tapering the Fed’s QE program will cut the value of government bonds purchased from USD 85 billion a month

‘Overall, the macroeconomic climate will be more favorable for stocks in 2014 than in 2013’ centrally directed budget policy have increased greatly in recent years, these will still turn out to be a paper tiger in practice, due to the lack of political support. The outcome of the European parliamentary elections in May 2014 will be an unsurprising but still unpleasant confirmation of this lack of support, says Cornelissen.”

The US also faces the potential wrath of voters after the world’s largest economy only averted debt default when the government was shut down amid wrangling over raising the debt ceiling. US Congressional elections will take place in November, potentially dislodging those Republicans who had opposed Democrat President Barack Obama during the shutdown.

Three scenarios for quantitative easing With regard to quantitative easing, there are three different scenarios, with differing likely outcomes. “Quantitative easing will come to an end in the US, will probably not start in

to zero over a period of six to nine months from March or April. “Limited long-term interest rate rises in the Eurozone and the US are likely, but this will probably not happen in Japan because of financial repression,” Cornelissen says.

That is because the extraordinary Japanese economic experiment known as ‘Abenomics’, in which Prime Minister Shinzo Abe has combined QE with an assault on deflation and a pledge for structural reform, faces its biggest test next year. VAT will be raised by three percentage points in April to encourage greater spending in the first quarter, thereby averting deflation.

But it runs the risk of triggering a recession

Speed Read – Higher growth seen in US and Europe – Long-term rate rises are likely – Equities are our preferred asset class – High-yield bonds best pick in fixed income

‘Less emphasis on austerity will support recovery in the Eurozone’ Léon Cornelissen, Chief Economist at Robeco similar to the one that followed the last VAT-rise experiment in 1997.

In the long-embattled Eurozone, Cornelissen expects “moderate economic recovery”, eventually rising above 1.0% a year. However, the chief economist warns: “Positive investment growth is also necessary to achieve recovery in the region. And it is necessary to control political tensions for this recovery to work.”

Mixed bag for emerging markets Globally, Cornelissen expects “moderately increased growth in the developed economies outside Japan”, but the picture for emerging markets is expected to be mixed.

“China will slow down to some extent, while other emerging markets will speed up to a limited degree”, says Cornelissen. “Accelerated Chinese growth is not sustainable and the authorities are again taking the path of monetary tightening. All in all, we are counting on growth in the order of 6.0% against 7.5% in 2013”.

“Because of the economic recovery in the developed world, we believe there is a plausible case for limited recovery in Brazil (where there are also elections in 2014), India and Russia.”

Earnings will be key to success for stocks “Overall, the macroeconomic climate will be more favorable for stocks in 2014 than in 2013,” he says. “Gradual interest rate rises in a low-

robeco outlook 2014

interest rate climate are a positive signal that the US economy is in principle strong enough to support corporate profits by increasing consumption and investments. But earnings will be the key to success in 2014.”

For emerging market debt, the current return on credit risk is 500 basis points. While this is 50 basis points higher than the equivalent return on high-yield corporate bonds with a similar duration, Cornelissen does not believe it

‘Expanding global growth combined with continuing loose monetary policy favors higher-risk asset classes’ Equity price rises in 2013 were mostly driven by stocks achieving higher multiples – a company’s share price divided by its earnings per share – as both profits and business sentiment generally improved due to stimulus from QE. This may not be repeated next year when QE begins to be withdrawn, Cornelissen warns.

“We expect to see a more gradual expansion of price/earnings ratios, modest profit growth and somewhat greater market volatility,” he says. “These factors will make it difficult for stocks to equal or exceed their excellent 2013 performance in 2014.”

will compensate for the significant currency risk seen in 2014. This is due to emerging markets currencies continuing to devalue against the US dollar as they struggle with economic growth.

“As emerging markets catch up economically, the current undervaluation of currencies (at this time over 40% based on purchasing power parity) will gradually translate into currency profits and offer solid returns on emerging market bonds in the longer term,” Cornelissen says.

Bond yields will gradually rise

For sovereign bonds, the Fed’s tapering plans mean higher yields - and bond values falling in tandem - as interest rates gradually rise.

In fixed income, high-yield bonds are preferred.

“Low interest-rate policies in recent years have given businesses sufficient opportunities to issue longer-term bonds at favorable rates,” says Cornelissen. “Still, we note that this asset class is losing some of its glamour. The reward for credit risk has dropped to 450 basis points and therefore lies below the 10-year average of 610 basis points.”

“Both US and German government bonds are approximately 100 basis points lower than one would expect due to money market interest rates, inflation and growth prospects,” says Cornelissen. “We expect that bond yields will gradually increase during 2014 towards the levels that would be appropriate with further increasing economic growth.”

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fixed income

Don’t expect a great rotation in 2014 Kommer van Trigt, head of rates team Looking out to 2014, we don’t think the great rotation will be with us. We do see healthy inflows in equity funds, but we don’t expect to see massive liquidations in fixed income funds.

And that is for a reason. First of all, central banks have kept official rates at very low levels – or in some cases even lowered them further, think about the ECB. We also see that the Fed and the Bank of Japan are still extending their balance sheets via QE operations. And finally if we look at demand for fixed income as being illustrated during auctions of corporate bonds or peripheral government bonds. We still see a very healthy demand. A lot of these auctions are heavily oversubscribed.

We remain positive on credit investments.

First, they still offer a healthy premium over treasuries. Second, if you look at the fundamentals of the corporates that we follow, in most cases fundamentals look okay, the cash positions are solid, and leverage is down. Also here we see healthy demand, due to amongst others increased regulations. So this is really a spot where we see opportunities for next year.

Additionally we can only think of the peripheral government bond markets in the euro area.

In our view, these bonds are still onderowned.

They also still offer healthy yield levels, and we have seen of course that the economic deterioration has come to a standstill – in some cases there is even reason for some optimism – so that could also help these markets.

Additionally, the backstop of the ECB, that was laid out more than a year ago, has also proven to be very successful for these markets.

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‘A lot of auctions of corporate bonds or peripheral government bonds are heavily oversubscribed’

Us markets

Earnings bode well for US equities Jay Feeney, CIO robeco investment management I remain constructive on the outlook for US equities. Earnings have rebounded to record highs since the bottoming-out period in 2009, and company profits are set to rise further in 2014 as the US economy continues to grow. Ultimately it is earnings that drive the market, so this bodes well for equity returns next year.

With the rerating of US equities, they now look more or less fairly valued. ‘Fair’ does not mean they are stuck in the mud – it implies a fair rate of return, and I believe that will be somewhere between 7% and 9% on an annualized basis going forward. One can arrive at that number from a range of different metrics, but a simple dividend yield of 2+% a year plus a conservative estimate of earnings growth of 5+% would produce such a rate of return.

The positives for 2014 are low inflation; good corporate earnings and cash flow; rising housing prices; the general health of the financial and banking system; the energy boom, and the US manufacturing renaissance.

But there are some negatives, which in the short term are really geopolitical, particularly concerning the gridlock in Washington. US corporations are flush with cash; they have accumulated very large reserves of excess liquidity. The biggest problem that is preventing them from using that cash flow to create growth is simply the lack of business confidence. GDP does not create jobs – businesses create jobs – and this will be important next year.

The whole debate about tapering isn’t that important – we know it’s going to happen,

robeco outlook 2014

and whether it happens in March or July, or somewhere inbetween, is really irrelevant. I don’t expect any major market ‘correction’ when we get some visibility on the exact timing.

I can’t stress enough that we at Robeco Investment Management engage in bottom-up stock picking, and we’ll invest where we find three characteristics: inexpensive valuations;

them have turned around their businesses by repositioning towards enterprise software or cloud services, and so to label them as ‘old tech’ is premature.

Healthcare is another interesting area. A lot of large pharmaceutical companies that had looming patent cliffs of many of their cash cow drugs have successfully navigated it, restructured their businesses, and now have a lot of promising pipelines.

Ultimately, there are only five things a company can do with its cash flow. It can pay dividends; buy back stock; pay down debt; reinvest in the business, or make acquisitions. Businesses thus far have been mostly focusing on the first three

‘Earnings have rebounded to record highs, and ultimately it is earnings that drive the market’ high quality, with sustainable cash flows that are deployed in a shareholder-friendly way; and an improving business that has momentum.

It doesn’t matter where these factors arise from a sector standpoint. However, I still view the financial companies as offering a combination of attractive valuations and generally improving momentum. Credit conditions remain favorable and the capital position of financials has been substantially restored.

Within technology, there is still a big debate over ‘old tech’ and ‘new tech’, but it is interesting to see how quick people are to write off the so-called ‘old tech’ companies if they’re not making something like tablets. Many of

ways to generate returns for shareholders. So there is some risk on whether companies will engage next year in reinvesting in the business or on M&A which may or may not be accretive to earnings.

The real positive bias will come if we can restore business confidence, navigate through the political gridlock and see companies hiring again. Then you’ve got the so-called virtuous, self-reinforcing cycle which can surprise to the upside, giving equities a more favorable backdrop which they haven’t had in the past couple of years. When you put it all together, with the positives and negatives, on balance there are certainly reasons to be optimistic about equities.

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Robeco Outlook 2014

Important information This document has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco) (Trade Register no. 24123167) is registered with the Netherlands Authority for the Financial Markets in Amsterdam. It is intended to provide the professional investor with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. The content of this document is based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness.

Robeco Coolsingel 120 3011 AG Rotterdam www.robeco.com